Subsidies, taxes, and queuing Today: Some methods that either hurt or improve efficiency

Today More on topics related to efficiency Subsidies Taxes Queuing and first-come, first-served policies

A subsidy for renters? Recall that last time, we concluded that rent control had few (if any) winners and many losers Suppose that we wanted to find another way to help I.V. renters How about a $500 check per month for each renter of I.V.?

Think, think, think As aspiring economists, we need to examine whether a subsidy is a good idea We must keep in mind Subsidy is not a “benefit” in economic terms, but a transfer Money for subsidy must be raised from somewhere

Short-run analysis In this case, we will look at the short- run consequences Assume for the near future, nobody can build new apartments or convert apartments to condos Supply is vertical

What happens? Initial demand is D After subsidy is given, each person is willing to pay $500 more than before, changing demand to D’

What happens? Before the subsidy, price is P2; quantity is Q1 With subsidy, quantity demanded at price P2 is Q2 In short-run, notice new price for apartments is P1 This price is $500 higher than before

What happens? All of the subsidy goes to the apartment owners (and we have not even found money for the subsidy yet!)

First-come, first-served policy This is essentially what happens today When a vacancy occurs, the manager accepts applications If the rent is at the market-clearing price: Each person willing to pay the price should find an apartment Each apartment should be rented

First-come, first-served policy What if the apartment is not at the market-clearing price? If the rent is below the market-clearing price, long lines develop If the rent is above the market-clearing price, the apartment will sit unoccupied

The inefficiencies of long lines In 1978, airlines adopted a voluntary approach to overbooked flights Before this, people were allowed to board on a first-come, first-served basis Remember to think like an economist: Waiting time is a loss to society that nobody benefits from

The inefficiencies of long lines Each person has a value of their time People on vacation typically have lower values of time than those traveling for work Let’s look at a tale of two people for a concrete example Max, who is ready to go on a skiing trip Jill, who has a business meeting tomorrow in Denver at Noon

Max, a single guy who likes to vacation in style

Jill, a busy executive at a local firm

They book seats on 6:05 am flight to Denver tomorrow

A tale of two people: Max Max has shopped at Vons for the last 12 years in order to accumulate enough miles to book his free flight He stays in Denver for one night before embarking on a two-week ski tour of Colorado

A tale of two people: Jill She receives a call tonight at 10 pm She must be in Denver tomorrow for a Noon meeting tomorrow, or else her local firm loses a $2 million contract She books an Economy seat to Denver for $775

Check-in for United flight 6682 Max and Jill are the last two people to check-in for the flight Jill is right behind Max in line Unfortunately, only one seat is left Should Jill be bumped?

Efficiency As economists, we want to find a way for the most efficient outcome to occur As an airline, we want to make ALL of our customers happy How do we do this?

Suppose that United cannot overbook its flight Empty seats Higher ticket prices Jill becomes desperate to find a way to Denver

With overbooked flights Voluntary system to find a person with a low value of time Offer an incentive so that someone is willing to travel on a later flight A First-class seat on the 1:45 pm flight to Denver

Cost-benefit analysis of incentive Max’s cost of waiting in Santa Barbara for eight hours is low, since he was just going to check into his hotel and eat a nice dinner at a local restaurant $10 cost per hour, or $80 total Jill loses a big contract if she does not make the flight $50,000 total cost

Cost-benefit analysis of incentive Assume that either Max or Jill benefits the same from a First-class seat $200 Max gains $120 by offering to give up his seat in order for Jill to attend her business meeting on time He instantly volunteers to give up his seat for Jill

Cost-benefit analysis of incentive Going from a first-come, first-served policy to a voluntary incentive system has improved the outcomes of both Max and Jill Max has improved by $120 and is traveling in style, just the way he wants Jill is able to make her meeting and save the contract

Pareto improvements When one or more people are made better off without making anyone else worse off, these are known as Pareto improvements In our previous example, both Max and Jill were made better off without making any other passenger worse off

Hypothetical cost-benefit analysis from United’s point of view United Airlines has determined in its computer system that the probability of the last First-class ticket being booked for the later flight is 0.05, at a price of $1200 The marginal cost of an a First-class passenger over an Economy passenger is $50

Cost-benefit analysis from United’s point of view Marginal benefit of booking Jill’s ticket: $775 Marginal cost of booking Jill’s ticket: Possible loss of First-class ticket being booked on the later flight, $60 Additional First-class cost of Max’s trip, $50 Total, $110 United is better off with this policy, too

In the text Demand curve is derived from reservation price (or highest willingness to pay) Max’s reservation price is low in this example Jill’s reservation price is high in this example People with low reservation prices will voluntarily accept the airline’s offer if the individual’s MB of the offer exceeds the MC of the time lost and inconvenience

What have we learned today? A subsidy, like rent control, is not a good solution for the I.V. rental market Voluntary incentives can be used to improve the efficiency of some markets Airlines use price discrimination to help achieve this (More on this in Ch. 10)